The private credit market continues its impressive growth trajectory, reaching an estimated $1.5 trillion at the start of 2024, up from approximately $1 trillion in 2020. Projections indicate that this market could expand to $2.8 trillion by 2028¹. This rapid growth has been driven by a confluence of factors, including tighter banking regulations, high inflation, and elevated interest rates. Even with the recent rate cuts, the appeal of this asset class remain evident.

In pursuit of more stable returns, the option of private debt continues as a front-runner for investors and as long as the significant stable returns continue, the appeal of private debt is unlikely to slow down any time soon.

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A Stable Return Realization

In 2024, inflation has started to ease in key markets. In the U.S., inflation fell from 2.9% in July to 2.5% in August², while in the UK, inflation dropped to 2.2% in July from 6.8% in the same period last year³. Despite these encouraging signs, interest rates, while beginning to decrease, remain elevated. This maintains the appeal of private debt investments, which continue to offer stable and attractive returns in this environment. Traditional fixed-income investments, such as bonds or Islamic Sukuks, still offer benefits when inflation and rates are stable. However, with rates decreasing, the return spread between public and private debt is expected to grow, maintaining the higher returns from private debt investors for longer.

Driven by demand for alternative asset classes with low volatility, consistent returns, low correlation against the broader financial market, private debt investments offer an attractive alternative.

Private debt investments have the advantage of:

• Dependable periodic returns
• A significant return premium over both bank deposits and public fixed-income securities
• Low correlation with public markets, lower price volatility
• Potential focus on sectors that offer strong growth trends

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Trade Finance Funds: Ideal for lower risk and Shariah-Compliant Investors

Private debt investment is a customizable strategy where investment managers provide companies with non-bank funding with a specifically tailored structure and terms. This is good for Shariah-compliant investors, as its flexibility enables the financing to be structured in a Shariah-compliant way, unlike public debt which is a standard structure. Due to regulatory limitations, these investments are not available through public markets, but they are accessible through investment funds managed by specialized asset managers.

Investors adhering to Shariah values can invest in private financing through either trade finance Wakala structures or equipment leasing vehicles.

Here, we focus on trade finance, which incorporates pre-negotiated trades to finance the processing and shipment of commodities.

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So, how does it work (from a Shariah-compliant perspective)?

A commodity trader wishes to purchase a specific commodity and sell it to an interested buyer. To do this, he needs funds to pay for the goods. An investment fund facilitates this by partnering with the trader as an agent, purchasing the goods or commodity, and selling it at an agreed profit margin while maintaining a security to safeguard against default and shipping risks.

In this scenario, the targeted return is agreed upon beforehand and the investment risk is minimized, with the value of the goods themselves providing the security. Due diligence is always carried out and all transactions are monitored using inspections, letters of credit, and insurance.  

Shariah-compliant Transaction Structure:

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Why is this a preferred solution for Shariah compliant investors?

This form of financing is especially suitable for Shariah-compliant investing because it allows for the actual goods to be traded, as opposed to providing the borrower the funds required against an interest payment. This may include commodities, non-perishable items and Shariah approved natural resources, such as base metals, energy products, and soft goods, like corn. All of these are highly liquid, meaning that they can be easily sold on open international markets.

Transactions such as these are typically short-term, allowing profit margins to reset to reflect changes in market conditions. Transactions are also fully secured against the commodity and can be structured so that they’re isolated from the counterparty’s balance sheet and its commitments. With no direct exposure to commodity prices, returns are highly reliable; credit and default risks are also sharply reduced.

From an Islamic finance perspective, by investing in such funds, investors can receive consistent monthly income while contributing to the real economy.

In addition, investing in public debt markets as a Shariah-compliant investor is challenging, largely because most Sukuks available for investments are geared towards emerging markets. This hurdle can be overcome within a private financing structure, meaning there’s no need to compromise on economic risks including political, currency, and other country-specific risks.

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Why You Should Consider Adding Trade Finance Funds to Your Portfolio

The inclusion of trade finance funds in an investment portfolio offers several advantages, particularly for those seeking greater certainty in a persistently fragile economic market. At the very least, the presence of a return premium over traditional fixed-income products provides investors with a level of return that counters the downward pressure that exists in high-inflation environments. But with such funds additionally providing liquidity, diversification, and low counterparty credit risk, it makes them an attractive investment option.

With the added benefit of offering strong return premiums along with a predictable risk profile, private financing funds are increasingly gaining traction as suitable for investors seeking stable returns while adhering to Shariah-compliant principles. Bank term deposits and real estate investments have simply not produced adequate income for many investors in recent periods and we anticipate the flow of funds into alternative asset classes, notably private debt, to continue.

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Author

Saad Adada, CFA

_Sources: ^‍

^{1 https://www.morganstanley.com/ideas/private-credit-outlook-considerations}

^{2 https://ycharts.com/indicators/us_inflation_rate}

^{3 https://www.bbc.co.uk/news/business-12196322}